Note: This is the latest entry in the Acton blog series, “What Christians Should Know About Economics.” For other entries in the series see this post.

The Term: Money

What it Means: In economics, money is a broad term that refers to any financial instrument that can fulfill the functions of money (more on that in a moment).

There are three basic ways to exchange goods and services: gifting (e.g., I give you a banana, expecting nothing in return); barter (e.g., I give you a banana, in exchange you give me an apple); by using money (e.g., I give you a banana, in exchange you give me $1). Money was invented (and reinvented in every culture) because it makes exchanges easier than the barter system.

What Money Is: Money is a shared belief system used to simplify exchanges of goods and services. To be used as money people have to share a belief that the item —whether paper, gold, rocks, etc. — can perform three main functions: be a store of value, be used as a unit of account, and serve as a medium of exchange.

In the next section we’ll examine these functions. For now, here are two examples of how money serves as a shared belief system:In the Caroline Islands of the western Pacific Ocean there is an island called Yap. For centuries the island had neither paper currency, nor metals such as gold, silver, or copper to use for minting coins. Instead, the islanders used limestone, which they had discovered on another island four hundred miles away. Because this stone was the most beautiful and precious commodity in the area, they made it their money.

Laborers would travel to that distant island to carve thick stone wheels called “rai” which range in height from one to twelve feet. At their center a hole would be cut so that a pole could be inserted for transport. Even with this change, though, the stones were too big and bulky to be carried to the local market. Instead, when payment was made, everyone would simply acknowledge that the rai belonged to the new owner and the stone would remain on the former owner’s premises.

One time a work crew was transporting a giant stone coin back to Yap on a raft and was met by a violent storm. To save their own lives, the workers dumped the stone into the ocean. As anthropologist William Henry Furness III wrote in 1910:

When they reached home, they all testified that the [rai] was of magnificent proportions and of extraordinary quality, and that it was lost through no fault of the owner. Thereupon it was universally conceded in their simple faith that the mere accident of its loss was too trifling to mention, and that a few hundred feet of water off shore ought not to affect its marketable value, since it was all chipped out in proper form. The purchasing power of that stone remains, therefore, as valid as if it were leaning visibly against the side of the owner’s house.

The concept of considering a stone on the bottom of the ocean—a stone that few people have ever seen—as a legitimate currency might seem absurd. But as the late economist Milton Friedman has noted, this story isn’t as unusual as it might sound. For instance, when the United States was on the gold standard, the Bank of France asked the Federal Reserve of New York to convert its dollar assets to gold. Rather than ship the gold across the Atlantic Ocean, the Federal Reserve requested that the gold remain in the Bank of France’s accounts. The French bankers went into their gold vaults and changed the labels to mark the gold as the property of France. After the relabeling, everyone involved considered the U.S. currency owned by the French, to be sufficiently backed by gold.

Both the stones of Yap and the gold in France reveal, said Friedman, how much unquestioned belief is necessary in monetary matters.

What money does: Money serves three essential functions: a store of value, a unit of account, and a medium of exchange.

Store of value – Imagine you got paid for your work in bananas. You’d need to spend them quickly since they’d rot within a few weeks. Bananas don’t work well as money because they don’t store value. To serve as money, an item needs to be durable, which is why cloth (like in dollar bills) and metal are often used as currency. (Money is not a perfect store of value, though, since inflation slowly erodes purchasing power over time.)

Unit of account – Money needs to be a store of value. But there also needs to be a way to measure that value. That’s why money also needs to be a unit of account — a standard monetary unit of measurement used for describing the value of something. The important characteristics of a unit of account includes (a) standardized and easily recognizable (e.g., all dollar bills look alike), (b) stability (e.g., as long as people trust the U.S. government, they’ll trust $1 is worth a dollars worth of goods and services), and (c) able to be broken up into components of equal value without losing value (e.g., a dollar can be divided into one hundred parts: one hundred cents = $1; a gold bar can be divided by weight).

Medium of exchange – Money serves as a medium of exchange when it is widely accepted as a method of payment (this where the shared belief system kicks in). A dollar bill is money because the U.S. government says so – and most people throughout the world agree to act as if it is money. Your personal check is also money because your bank will exchange it for currency. Gold was frequently used as money because people share the belief that it has value.

Types of money: The main two types of money are fiat money and commodity money.

Most global currencies are fiat money—money that has value only because of government regulation or law. Fiat money is not convertible by law into anything other than itself, such as gold or silver, and has no fixed value in terms of an objective standard—it’s value can fluctuate based on numerous economic factors.

In contrast, commodity money is a medium of exchange that may be transformed into a commodity, useful in production or consumption. Commodity money can be based on minerals (e.g., gold or silver), found objects (e.g., shells or stones), consumer good (e.g., cigarettes in prison or POW camps), or even digital bits (e.g., Bitcoin).

Although commodity money was the dominant medium for exchange for thousands of years (think gold and silver), it has fallen out of favor because it limits the scope for monetary policy and other actions that alter the value of money.

Other Stuff You Might Want to Know:

• Legal tender is money recognized by a legal system to be valid for meeting a financial obligation. Paper currency and coins are common forms of legal tender in many countries.

• The “money supply” is all the financial instruments (items that can serve as money) within an economy. Financial instruments can be added together to form “monetary aggregates,” which are subsets of the total money supply.

• The most commonly used monetary aggregates are designated M1, M2 and M3. M1 is currency (coins and bills) plus demand deposits (such as checking accounts); M2 is M1 plus savings accounts and certificates of deposit (i.e., bank CDs) under $100,000; and M3 is M2 plus larger time deposits and similar institutional accounts.

• In the American economy, only about 10 percent of the money supply is in physical currency.

• The money supply is expanded through the modern banking system in two ways:

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Thanks for this Joe. This was very interesting. I was rereading Aristotle on the nature of money (Ethics Bk 5 Ch 5) and I was pleasantly surprised to see that he identified all three of the “functions” of money in that chapter. In working through my thinking on money, I would propose a different way of thinking about the functions. Let me offer first an Aristotelian example.
Let us consider a saw. The “matter” of a saw is anything that can take the shape or form of the saw. This could be almost any solid, dirt, clay, wood, ice, gold, steel, etc. This is what is potentially a saw. The form of a saw is the shape or structure characteristic of a saw, that is sharp teeth formed in a regular way along with a mechanism for motion. This is what is a saw. The purpose or function of a saw is cutting. It is this purpose that both determines what is a good saw and what matter has the disposition to becoming a saw. Dirt is not well disposed to receiving the form of a saw and ice and gold are not good saws because they don’t cut well. Further the shape of a saw is determined by this purpose. A blunt saw is not good at cutting for example.
Now, consider money. The matter of money is something with value that can be exchange, namely a store of value or any property. A unit of account or measure of value is what is money. As a measure of value, money must be something with value, because a measure must in someway contain what it measures, as a ruler has extension to measure length. The purpose of money is as a medium of exchange. This is what determine good money. Any property can be money in so far as it is valuable and exchangeable, but something that is good money will retain its value and not fluctuate greatly overtime. A ruler that changes dimensions rapidly and significantly is useless as a measure of distance. So, a good store of value is good money. Moreover, being a measure of value as the form is determined as a medium of exchange, for money provides a single unit against which to measure incommensurately valuable things in exchange.
One of the difficulties though is talking about the “money supply.” Since anything with value whether relatively stable or not can and is used as money, it seems at least dubious to talk about the money supply. One can reasonably talk about the currency supply, but the M1 form of money includes both currency and demand deposits, which are certain claims for return of currency on demand, but are essentially different from deposits. I was recently reading Thomas Wood’s “The Church and the Market” in his discussion of money wherein he claims that commodities and demand deposits of commodities are the same. This is a significant category error as a commodity and a security are essentially different things and need to be properly distinguished even if both can and are used as money.
Another interesting result of realizing that any property can and is used as money is that money is no special thing as essentially distinct from other property and that all exchange is barter. It is simply in the case of money that a single valuable sort of thing is used as the measure of all other valuable things, that is it is the one thing that everyone agrees to barter with.
This is at least the sum of my attempt to understand the nature of money.

http://rdmckinney.blogspot.com Roger McKinney

“Since anything with value whether relatively stable or not can and is used as money, it seems at least dubious to talk about the money supply.”

That’s because you’re thinking in terms of realism. You mentioned once that you would like to create economic theory based on realism. But you’ll find that is classical economics from Adam Smith to Karl Menger. They tried to analyze prices by intrinsic value and by the labor theory of value. But it led to many paradoxes exemplified by the diamond vs water problem. Ricardo and others couldn’t figure out why diamonds had greater value than water which is much more useful, even necessary for life. They never got beyond that problem until the marginal/subjective revolution started by Menger and others. They realized that people don’t value all diamonds and all water, but only those small amounts they need at a particular time. So they buy water first and if they have money left over after meeting other needs, they buy diamonds last. But the vast supply of water means they can get all they need for very little expense, but the supply of diamonds is much more restricted and difficult to get. So they have to pay the owners much more.

The same goes for money, but you have to drop the intrinsic value idea. If you don’t, you will never understand money at all. Classical economists never understood money, either, which is why their advances in economics were very limited. The greatest advance in economics only came after Menger’s marginal revolution. In economics, supply plays as much a role in determining price as does demand and that goes for money.

Philosophical Actuary

This reprieve was all too short. If you would attempt to understand what I have written in several places here, it might be worthwhile to continue. However, you will endlessly fight or grumble at a straw man with your distaste of someone else’s terms and positions.

http://rdmckinney.blogspot.com Roger McKinney

Would you mind responding to my point that classical economists held to your position about money and failed to understand how the economy works. Economics didn’t make progress until economists abandoned your ideas. That’s not just grumbling. That’s historical and economic fact.

Philosophical Actuary

I did. You committed a straw man by attributing to me a view I don’t hold.

http://rdmckinney.blogspot.com Roger McKinney

Me thinks you protest too much. I see no straw man because there isn’t one. In case you haven’t noticed, I’m the only one who responds to your posts. I wouldn’t have responded to this one except I was confused and thought you actually wanted to discuss monetary theory.

Philosophical Actuary

I’m hesitant to converse with you as you habitually misunderstand me, accuse me holding positions I don’t, and make fallacious arguments. However, I at least will clarify myself.
In the first quote, you grossly misunderstand me. It seems you think I’m questioning the nature of supply and demand in attributing the views of classical economists upon me. I don’t and the marginal revolution appears more of a catching up with the 3rd century BC where Aristotle already knew that value depends on someone’s needs and desires.
I mean simply that if anything of value can be used as money, what IS the money supply? Since it is not essentially different from other sorts of property, when we speak of the money supply what are we attempting to identify and quantify? The above definitions of M1, M2 and M3 appear simply arbitrary including currency and some very liquid securities.
In the second, I suppose Thomas Woods is not a economist, but does seem to fail to distinguish between a commodity and a security with a right to return of the commodity upon demand and says its an important conceptual point to conflate them. Similarly in the case of fractional reserve banking, the growth of the money supply is at least magically explained and seems fails to distinguish between money in the financial system and property claims in the financial system.

http://rdmckinney.blogspot.com Roger McKinney

I apologize for misunderstanding.

Yeah determining the money supply is difficult because so many things can be used like money. Austrian economists have their own definitions. It’s difficult because so many things can be converted to cash easily and quickly. For example, if I have a gold ring that I can exchange for cash easily at a pawn shop that can be cash.

But the most important form of money is credit that banks can create on their own. It makes up about 90% of our money and is the one source of money that causes all of the problems. None of the other sources of money cause any problems at all. But expanding the money supply through credit expansion caused a lot of problems, not the least of which is booms and busts.

Philosophical Actuary

I appreciate your apology.
Let me ask a few questions. What is the Austrian definition of the money supply and its justification? How do you know that 90% of the money supply is credit from banks given the difficulty of identifying the money supply? What are the problems your are referring to? Is the problem with credit as such, bank credit in particular and/or specific kinds of bank credit? Are booms and busts or the business cycle generally a problem with the economy or part of its natural rhythm?